Accounting For Leases: Capital or Operating?

Nov 03, 2015

As business owners you may or may not be aware of the differences in accounting for a capital lease vs. an operating lease, or the future changes to be made to accounting standards. We are here to help!

Let’s begin with the basics of how we have historically accounted for leases under Generally Accepted Accounting Principles (GAAP). Capital lease or operating lease?

capital lease is a lease which transfers substantially all of the benefits and risks of ownership of the leased item from the lessor to the lessee. A lease is considered a capital lease if it meets one or more of the following criteria:

  • The lease transfers ownership of the property to the lessee by the end of the lease term.
  • The lease contains a bargain purchase option. This is an option permitting the lessee to renew the lease or purchase the leased property for an amount that is sufficiently below expected future market value at the date the option becomes exercisable.
  • The present value of the minimum lease payments is at least 90% of the fair value of the leased property.
  • The lease term is at least 75% or more of the estimated economic life of the leased property.

Legal_Contract1For a capital lease, the transaction is treated as if an asset were being acquired with a corresponding liability incurred. At the beginning of the lease, the lessee records the present value of all future lease payments as the cost of the lease then record only the interest portion of each payment as an expense then recognize the disposal of the asset at the end of the useful life. The asset and liability are recorded at the lower of the present value of the minimum lease payments over the lease term; or the fair market value of the asset at inception of the lease.

An operating lease is any lease that does not meet one or more of the criteria for a capital lease. When accounting for an operating lease, the rented asset and the corresponding long-term liability are not recorded. Instead, rent expenses are debited periodically and cash (or a short-term accrued liability) is credited.

The Financial Accounting Standards Board (FASB) and International Accounting Standards Board (IASB) have been working together to modify accounting for the rights and obligations regarding leases. The proposed accounting standards update primarily affects accounting for operating leases. The project has proposed recording long-term operating leases onto the lessee’s balance sheet. All long term leases will be recognized as either a capital lease or an operating lease for amortization purposes. Therefore, a leased asset and a leased liability will be recognized by capitalizing the present value of the operating lease commitments.

For lessees, recognizing lease-related assets and liabilities could have significant financial reporting and business implications. A couple implications that might be affected are debt covenants and borrowing ability, decisions about whether to lease or buy significant assets, and possibly the cost of borrowing, etc. Currently, these items have an effective date of January 1, 2018 or later. There is still a lot up in the air right now. Things could change and there are potential revisions to be made before it becomes effective.

By: Aubrey Forche, Staff Accountant

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